Analysis: Russia's biggest contingent liability: oil

MOSCOW (Reuters) - With a sovereign debt of just 10 percent of GDP and half a trillion dollars in reserves, Russia has a balance sheet that the United States and Europe can only envy as they battle their debt crises.

But a closer look at Finance Minister Alexei Kudrin's latest fiscal plans reveals two concerns: he is betting that oil prices will stay high for years; and even if he is right, the pace of budget consolidation will slow significantly.

By his own reckoning, the books would only balance with oil at $125 per barrel next year, reflecting the impact on the public finances of the global slump that put an end to years of surpluses generated at much lower oil prices.

Kudrin has only managed to keep the projected deficit below 3 percent of gross domestic product (GDP) over the three-year budget horizon by hiking his oil price forecast to the mid-$90s from the high $70s previously.

Even then, the fiscal strategy abandons a previous goal of balancing the budget by 2015. After stripping out energy revenues -- which account for nearly half of the tax take -- the deficit will stay over 10 percent of GDP.

"Given the very high oil price forecast, the slow fiscal consolidation is disappointing," said Ivan Tchakarov, chief economist at Renaissance Capital. "The oil sensitivity of the budget has increased dramatically."

In rough terms, a $10 fall in the oil price would translate into an increase of one percentage point in the deficit for the world's largest oil and gas producer.

"With oil at $95 everybody's happy," said Sergei Guriev, rector of Moscow's New Economic School. "But at $70, borrowing becomes hard for both companies and the government."

On the spending side, the government has locked itself into higher pension outlays, increasing budget transfers from 1.5 percent of GDP in 2008 to 5.2 percent in 2010, Yevsei Gurvich, head of the Economic Expert Group, wrote in a recent study.

An offsetting hike in payroll taxes will be partly unwound next year on the orders of President Dmitry Medvedev, who is likely to run for a second term next March if Prime Minister Vladimir Putin chooses not to return to Russia's highest office.

That will swell the largest budget item, social spending, which will rise in 2012 by 20 percent to 3.8 trillion roubles ($135 billion), accounting for 31 percent of federal outlays.

Put another way, Russia will spend four-fifths of its energy revenues on welfare. The cost of the pension system, if left unreformed, could "completely undermine the stability of the budget system," Gurvich wrote.

Kudrin will present his budget to parliament in the autumn.

DOWNSIDE ACCELERATORS

Even if those costs are bearable under a sanguine view on oil, they would become difficult to sustain in the event of a sharp and sustained oil price crash due to other contingent liabilities that are, effectively, derivatives on the oil price.

Chief of those are debts owed by large state-controlled firms, such as energy majors Gazprom and Rosneft and banks Sberbank and VTB.

Economists at Deutsche Bank have estimated that a contingent liability shock caused by such "quasi-sovereign" entities could add 10 percentage points to Russia's national debt by 2020.

That would raise sovereign debt to 40 percent of GDP from Deutsche's baseline case of 30 percent, "a level associated with increasing debt sustainability problems in emerging markets," Maria Arakelyan and Thorsten Nestmann wrote in a research note.

Although Russia's banks survived the global financial crisis in decent shape, confidence has been shaken by the collapse of Bank of Moscow, Russia's fifth-largest bank, after a hostile takeover bid by VTB.

A central bank audit, conducted after Bank of Moscow management was ousted, uncovered a web of related-party lending that will have to be written off. That triggered a record $14 billion bailout -- costing almost 1 percent of GDP.

Given glaring regulatory lapses and the growth ambitions of state-controlled banks, a far more costly bailout cannot be ruled out if an oil crash hits Russia's creditworthiness.

SCOPE TO RESPOND

Still, economists note, policy makers have learned from the crisis after blowing $200 billion in reserves to defend the rouble, a futile exercise that is unlikely to be repeated.

A more flexible currency would absorb the impact of an oil-price shock, supporting rouble-denominated revenues, while Russia's external vulnerability has been reduced as firms have extended maturities on their foreign debt, they add.

Russia can head off trouble if it undertakes an ambitious pensions reform that would raise the retirement age and ensure that only the deserving get the minimum state pension.

And Medvedev's push to accelerate privatization, which under one government proposal would treble annual proceeds to $30 billion, would also help reduce quasi-sovereign liabilities.

"There has been no real stress test of the fiscal position," said Guriev of Russia's oil dependency and the systemic risks that extend from it. "There is a growing understanding of these issues (in government), but nothing will happen before the elections."